Accounting equation
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The basic accounting equation is the foundation for the double-entry bookkeeping system. It shows how assets were financed: either by borrowing money from someone (liability) or by paying your own money (shareholders' equity).
- Assets = Liabilities + (Shareholders or Owners equity)[1]
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[edit] How it works
For example: A student buys a computer for $945. This student borrowed $500 from his best friend and saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.
The formula can be rewritten:
- Assets − Liabilities = (Shareholders or Owners equity)[1]
Now it shows owner's interest is equal to property (assets) minus debts (liabilities). Since in a company owners are shareholders, owner's interest is called shareholder's equity. Every accounting transaction affects at least one element of the equation, but always balances. Simplest transactions also include:[2]
| Transaction Number |
Assets | Liabilities | Shareholder's Equity |
Explanation | |||
|---|---|---|---|---|---|---|---|
| 1 | + | 6,000 | + | 6,000 | Issuing stocks for cash or other assets | ||
| 2 | + | 10,000 | + | 10,000 | Buying assets by borrowing money (taking a loan from a bank or simply buying on credit) | ||
| 3 | - | 900 | - | 900 | Selling assets for cash to pay off liabilities: both assets and liabilitiies are reduced | ||
| 4 | + | 1,000 | + | 400 | + | 600 | Buying assets by paying cash by shareholder's money (600) and by borrowing money (400) |
| 5 | + | 700 | + | 700 | Earning revenues | ||
| 6 | - | 200 | - | 200 | Paying expenses (e.g. rent or professional fees) or dividends | ||
| 7 | + | 100 | - | 100 | Recording expenses, but not paying them at the moment | ||
| 8 | - | 500 | - | 500 | Paying a debt that you owe | ||
| 9 | 0 | 0 | 0 | Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities | |||
These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.
Also, the equation can be rewritten as:
- Assets = Liabilities + Owners equity + (Revenue - Expenses)
OR
- Assets + Expenses = Liabilities + Owners equity + Revenue
This is often referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation. [3]
[edit] Balance sheet
An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity, as well as totals to ensure that it balances.
[edit] History
Luca Pacioli is notable for including the first published description of the method of keeping accounts that Venetian merchants used during the Italian Renaissance, known as the double-entry accounting system.
[edit] References
- ^ a b Meigs and Meigs. Financial Accounting, Fourth Edition. McGraw-Hill, 1983. pp.19-20.
- ^ Accounting equation explanation with examples, accountingcoach.com.
- ^ Wild.Financial Accounting, Third Edition.McGraw-Hill, 2005. p.13
